Hold All Tickets: We’re Just Getting Started

In an effort to fulfill one of the new administration’s major campaign promises, the House Ways and Means Committee finally put forth a proposed tax reform package last week. Since that time, most of the major news outlets have devoted considerable time and attention to the bill, with much of the discussion likened to a horse race: “Who’s winning? Who’s losing? When will the bill cross the line into law?”

The big questions in the investment world are how will the markets react to the legislation, and how much of the effects of tax reform are already “baked in” current securities prices. In other words, if stock valuations are based on the current tax structure and legislation is passed that significantly lowers corporate tax bills (thereby boosting corporate earnings), then successful passage could bring a significant jump in the stock prices. Conversely, if stock prices already reflect a meaningful increase in earnings (resulting from lower tax rates) and reform isn’t passed (or at least not to the extent investors think), then stocks could see a pullback.

Early this year I was concerned that the anticipatory rise in stock prices, known as the “Trump Bump”, was unjustified. My concern was that stock prices were climbing relentlessly higher based on expectations of policy changes that had not even been written yet. Moreover, the odds of successful passage had to be lower given the polarization and lack of collegiality that characterized not only the presidential election but also the last several years on Capitol Hill. I was accused of being a curmudgeon, which I always take with some pride: it’s important that skepticism tempers optimism when managing clients’ interests.

As the year progressed, pessimism waned somewhat as earnings’ growth has proven stronger than many (including me) had expected. The rise in earnings (especially in the energy sector) seems to justify some of the exuberance that was on display early in the year. In other words, the fundamentals caught up with the valuations. And while the markets taken as a whole are still expensive (and certain individual sectors and stocks wildly so), they aren’t unrealistically disconnected given the backdrop of a steadily expanding economy. But again, it doesn’t appear that earnings growth tells the whole story. There is still clearly some level of premium in stock prices that is based on as-yet unfulfilled promises.

The question is not simply whether or not tax reform gets passed. Something may or may not get done next year given that it’s an election year. The pressure of midterm elections weighs on both parties. But the bigger question is likely to be, in what form the bill ultimately may be passed. The House version of the tax bill just began the “markup” process of amendments in committee on Monday. It still has to pass the committee and then be debated and voted on the floor. The Senate has yet to release its version of the bill, and the early indications are that it will be substantially different from the House version (including contentious issues such as the phasing in of lower corporate rates and differences in the deductibility of state and local taxes for individuals).

Every member in both houses will be feeling pressure from special interest groups, but it should be kept in mind that “special interests” are groups of citizens who have a right to petition their government. For example, homebuilders and realtors are fighting to retain the mortgage-interest deduction (MID) – a boon not only to those purchasing a home valued between $500,000 and $1,000,000 but also to those working in housing-related industries (construction, building products, home improvement, mortgage lending, real estate agency, etc). While the percentage of the population directly affected by a change in the MID is relatively small, the repercussions are large. Some publicly traded construction companies took a beating in the market on Monday, as did Home Depot and Lowe’s, when the details of the House plan came out. But then again, the introduction of a bill is far from a change in policy.

The tax code is extraordinarily complex, and it is of near universal consensus that simplification would have many positive side effects. Aside from how simplification would negatively impact the tax preparation complex, it is also important to remember that every “loophole” created for a “special interest” was passed by majorities in both houses and signed by a president. Every deduction had a reason for being written. Although some of those reasons may be perfectly valid (the MID deduction incentivizes home ownership), some deductions may have had unintended consequences, and some may have just been bad ideas. The point is that any and all changes to financial incentives effectively result in changes to the ground rules for the economy. Small differences can have ripple effects far beyond the obvious increase or decrease in an individual or company’s tax rates.

Investment analysts are charged with understanding the ramifications of tax-policy changes as one aspect of any individual company’s fundamentals. As the process of sausage making continues, we will gain a better understanding of how any final version of the bill will affect companies in various industries. At this point, it remains too early to make significant changes in your investment portfolio based on policy initiatives that may or may not materialize. But hold all tickets, because the final version of the bill could contain provisions that will affect your long-term investments.

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